The great bailout: U of M expert on mortgage crisis says Paulson plan is ‘reverse criminal action’

For some consumer-rights advocates, the great Wall Street bailout is starting to look like a heist for the ages. Prentiss Cox, a professor of law at the U of M and former assistant attorney general, calls Treasury Secretary Henry Paulson’s bill “outrageous.” Wall Street was the cause of the problem, he says. “And now they want a bailout completely on their terms? It serves the very wealthy and completely ignores the homeowners victimized by this. It is appalling.”

Indeed, as Congress scrambles to shore up the mess on Wall Street with more than a trillion dollars in bailouts, many homeowners are still drowning in debt due to the nefarious lending practices that created the crisis in the first place. Not only will they be saddled with the increasing deficit and footing the bill for the trillion-dollar-plus Wall Street bailout, they’re stuck with bills they can’t pay and facing foreclosure and bankruptcy because of the shady lending practices that brought on the bailout.

Here in Minnesota, home prices in some areas have plummeted by more than 20 percent. Nationwide, prices have dropped 18.4 percent since July 2006, according to the Standard & Poor’s/Case-Shiller 20-city index. And while Treasury Secretary Henry Paulson claims a “housing rebound” is around the corner, Minnesota’s housing market appears to be facing a long stretch of trouble.

For one thing, the Joint Economic Committee estimates that Minnesota will see another 27,871 foreclosures by the end of 2009. That’s due in part to the fact that 57,000 Minnesotans, or approximately 25 percent of those who still have Adjustable Rate Mortgages, will see their rates increase in the next year. Add to that the problem of declining home prices—which some experts predict could fall as much as another 25 percent in the next three years—negative equity, and more homes being dumped on the market, and that rebound looks more like a deep puncture.

In fact, the Center for Responsible Lending estimates that 8,000 families each day are going into foreclosure, and that over the next five years, about 1 in 8 mortgages in the U.S. will go into foreclosure. That’s 6.5 million foreclosures. And while the Bush Administration’s plan offers a handout to those responsible, it has yet to address the serious issues facing homeowners who were victims of egregious lending and grab-and-go greed.

“This is just absurd,” Cox says of the current bailout plan. “It’s like a reverse criminal action where you give restitution to the criminals and put the victims in jail.” Cox talks to MnIndy about how we got here and why the bailout needs to change.

MnIndy: With the Bush Administration’s current plan, it’s as if no one wants to discuss how the crisis happened and instead only wants a quick-fix cover-up. You know, there’s “no time for the blame game” kind of philosophy. So how did we get here? And who is responsible?

Prentiss Cox: The fact that we are spending a substantial part of the next generation’s income on this bailout is astounding. The people who were really responsible for this catastrophe are for the most part left wealthy, and in the case of Wall Street, feel the right to shape the terms of the bailout. Wall Street was one of the parties responsible for the problem. So it takes amazing shamelessness for Wall Street to demand that it has this bailout without any other restrictions or any help for homeowners who were victimized.

We got here in a fairly direct manner. First, we had massively irresponsible and unfair lending primarily by unregulated institutions. That lending was funded and to a large part shaped by Wall Street. And those Wall Street investment firms knew early on what they were dealing with. In the first major predatory lending case against a company called First Alliance Mortgage Company, Lehman Bros., who’s now in the news, had a memo saying, “If we want to deal with this company we have to check our morals at the door.” And that was over ten years ago. So Wall Street knew what they were dealing with when they were dealing with these subprime mortgage companies, and they financed them anyway.

Prentiss Cox

Then, there was a second wave that started around 2003 and 2004. In that wave, Wall Street flooded the market with massive amounts of money and helped shape the terms of the kinds of loans that would be made. And that lending spread far beyond the stand-alone subprime companies and became standard industry lending practice. It’s really that second wave that led to the scope of the catastrophe that we’re dealing with now.

MnIndy: So we’re talking here about the Alt-As and no-doc loans that still have to shake out of the market.

Cox: It allowed loans to be made without adequate underwriting for quick fees. The primary attributes were, number one, lending to homeowners with no down payment; number two, lending to homeowners with teaser rates that would explode even if the interest rates were stable; And number three, encouraging homeowners to use stated income. The worst borrowers encouraged borrowers to make up specific stories that you would see over and over again in loan documents.

Fourth, there were loans that trapped homeowners with pre-payment penalties and high fees that ate away substantial amounts of equity. And fifth, there was lots of fraud, including fraudulent appraisals. All of this was undergirded by the belief that home prices would continue to escalate and cover up all the sins.

So that’s how we got here. Wall Street firms funded it all. And banks and other major institutions also made and bought a substantial amount of these loans so that the pain is spread fairly large and wide.

MnIndy: We know this has been going on for years. And then finally, last August of 2007, we saw the height of the foreclosure crisis hitting homeowners. Why did it take so long for the Bush administration to finally call this a serious problem?

Cox: This was a disaster before it was a crisis. And what I mean by that is families and homeowners were being negatively affected by these unfair and imprudent loan products before the financial collapse. The reason we didn’t hear about it is because we treated them as individual tragedies. The homeowners were either able to sell their homes because of the rapidly appreciating prices or refinance into an even worse and riskier loan.
So the housing appreciation allowed a cover for the risky loans and made them appear better products than they were. So when the housing values started to fall everything went into reverse.

MnIndy: Regardless of the Wall Street bailout, homeowners still have falling home prices to contend with. Yet Paulson says a “housing rebound” will ensure that taxpayers won’t be stuck with the nearly trillion dollar bailout package for Wall Street. Is that even feasible that taxpayers won’t be stuck with it given that a rebound looks dubious?

Cox: I think it’s really unclear. I think that anyone who thinks they know the answers to this has a crystal ball I don’t have. Of course the Treasury Secretary is going to say that we can expect a rebound because he is trying to get the biggest bailout in U.S. history by a fairly wide margin, and he wants it done with almost no strings or regulations. And most importantly, he wants it done in a way that harms homeowners. He calls that a “clean” bill. Anyone who wants to do anything to help the victims is complicating the “clean” bill.

But I don’t think that it’s realistic to say that we will recoup the money. There’s a chance it could happen, it happened in Sweden when that market faced a collapse in the early nineties. But there’s a key difference here: They drove a much stronger bargain with the collapsed industries. This is simply a “we’re giving all this money to Wall Street and trust us” bill. This isn’t a thought-out policy. This is a “we have such a good track record with these things, trust us,” which gives one pause.

MnIndy: What can homeowners expect from the bailout? The Democrats’ bankruptcy provisions aside, under Paulson’s plan, is there any chance the bailout could affect homeowners positively, like opening up more loans and allowing them to refinance? Or are we just talking about a bailout for the investors who caused the crisis and leaving homeowners and taxpayers footing the bill once again?

Cox: That’s the real question. Look, this is outrageous. I mean, is it necessary to do a $700 billion bailout? Probably. We probably needed to do all of these bailouts. They tried to contain it. It wasn’t containable. So they probably need to do an incredibly bold stroke like this in order to restore the market, pull out the assets, and deal with them rationally. While it’s unbelievable that we got to this place, given that we’re here, a bailout seems to be a rational policy choice.

What makes my jaw drop is we’re doing this in a way that completely ignores any possible assistance for homeowners who were victimized by this. And in fact, just to rub salt into the wounds, the bill probably will result in limiting existing defenses to foreclosure and protections that individual homeowners have under existing law when they default on their mortgage, because it’s a federalization and federal law would preempt many of those protections and wipe out those defenses, as sometimes happens when the FDIC takes over an institution.

So that is incredible. This is just absurd. This is like a reverse criminal action where you give restitution to the criminals and put the victims in jail. I have been astounded from day one that so many people are so comfortable basically socializing business risk to a degree never seen before in our country while at the same time completely ignoring any help, I mean any help, for homeowners.

MnIndy: You mentioned earlier that home declines were seen as an individual crisis and not necessarily a systemic problem. Is it a type of thinking that foreclosures and home-price declines are individual cases, or “individual responsibilities,” part of the reason homeowners are being ignored the victims in this case?

Cox: It’s that homeowners don’t rate. They don’t rate a thought or a mention here. When you do try to help, like we did with the Foreclosure Deferment Bill last year, which is looking pretty darn good at this point, you get these ridiculous lines like, ‘We don’t want to interfere in the market.’ Take a step back, folks! We’re giving a trillion dollars to these institutions that caused these problems.

We’re socializing our financial system. We’re socializing the wealthiest and largest players in our financial system to an unbelievable degree. But we don’t want to help the homeowners and families who were victimized by these loans. It boggles the mind. It truly boggles the mind that people can hold those principles together in their mind and not cringe.

MnIndy: It goes back to the decades’-old idea of the “invisible hand” of the market that’s been at the center of discussions about the foreclosure crisis from the beginning. Let it work itself out, except when it affects Wall Street. How much of this is about politics and clinging to a philosophy than addressing the reality of the situation?

Cox: It absolutely has become about that. If you’re truly a real free marketer, how can you suddenly support all these bailouts? It’s comfortable for me to support both, because I don’t believe markets have much capacity to exist outside of reasonable public control and limits. So for me, subsidizing the markets was a result of our terrible thinking over the last 25 years. I would use the word “childish” thinking about the ability of financial markets to police themselves.

So it doesn’t surprise me that we need to do this. But the idea that we need to enact socialism for business risk, but believing basic government protections–even when they don’t cost money to the public–for homeowners who were caught in this disaster is somehow an affront to the free market and availability of credit is a ludicrous and contradictory position. It speaks not well of our politics that people can hold that position without having to defend themselves from questions about the obviously discordant nature of their views.

MnIndy: Out of this, too, it seems it’s only fueled the same political rhetoric and denial. But a clear analysis and call for action beyond the market crisis seems to still be missing.

Cox: It’s become out of control. McCain’s people have this rhetoric about greed on Wall Street and firing the SEC commissioner? Why don’t they jut fire the Idaho health-department commissioner? It’d be the same thing. It is not how we got into this mess. It is just absurd rhetoric. And, again, we have a poverty of political discourse that a comment like that that isn’t met with howls of incredulity. It’s an absurd statement. And underlying it is a total lack of a policy that will deal with this in any way that will actually help people.

And Obama’s plan is timid. It’s been timid since the beginning. It’s a little more of a step in the right direction. But it never grasped the magnitude of the problem or the need for strong public control over the process to protect the most number of homeowners. All of which is entirely doable. It’s simply a matter of political will. And I really hope that Democrats finally get a backbone and put in provisions that will actually help homeowners.

MnIndy: What is it that the candidates—and especially the Paulson bailout—is missing? Are we talking simply about a provision that would help homeowners in bankruptcy? Are we talking about allowing homeowners facing foreclosure to refinance? What about those facing negative equity?

Cox: If we’re talking about a national solution, helping homeowners means enforced loan modification. That’s number one. So we just have to take the people who are in trouble or in default on their mortgages, and we have to rewrite these loans in a way that’s fair. You can’t save everybody. You can’t save more than half the people at most.

But these risky loans a huge part of the part of the problem. And you’ve saved a lot of homeowners, you’ve prevented properties from being dumped on the market. The homeowners aren’t going to get a bail out. No matter how you do it, they will still pay for their mortgage. But they might get some balancing of the leverage, so that homeowners have something to come to the table with that will allow them to survive.

The second thing that should happen is preserving and creating more rights for homeowners who were victims of the worst kinds of lending to allow them to recoup their losses. And the third thing, and most important in the long run, is effective regulatory structure. These kinds of things are happening not only with mortgages, but the underlying causes that drove refinancing and the crisis, which is consumer debt in America and they way we don’t regulate consumer debt.

We’ve lost critical years since this crisis started. In the year and a half since we’ve been deep in it, we have done zero, in capital letters, ZERO, to force lenders to force lenders to enter in to reasonable accommodations with homeowners. We have press release after press release after press release about voluntary measures, none of which have done anything to end the problem. They’re just a lot of press releases. And homeowners are still the real victims in all of this.